The Top 10 Buffett Stocks

Warren Buffett famously made his billions by watching excellent companies and buying them when the price was right. But how does Buffett identify these great businesses in the first place?

Well, to a large degree his process is qualitative and intuitive: He uses experience, inference, and pattern recognition to figure out which businesses have strong and growing pricing power. But there are also some tell-tale quantitative signs of a massive competitive advantage.

One clear indicator
My colleague Matt Koppenheffer caught this fascinating tidbit from Buffett's most recent letter to Berkshire Hathaway (NYSE: BRK-B  ) shareholders that reveals one way Buffett thinks about measuring excellence:

When evaluating Berkshire's manufacturing, service, and retailing businesses, Buffett writes: "Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12%-20%."

It's an intriguing metric. Essentially, what Matt and I have been dubbing "the Buffett Ratio" captures the economic strength of a company.

I've been using the metric to generate stock ideas for the Dada portfolio that I co-manage and thought I'd share with you the ten highest-ranking companies based on the Buffett Ratio.

Confirming that we're on the right track, two of the 10 companies listed -- Kraft and Ingersoll-Rand -- are already Berkshire holdings.

Company

Industry

Buffett Ratio

John A. Wiley & Sons

Publishing

8,280%

Altria (NYSE: MO  )

Cigarettes

4,822%

Hologic (Nasdaq: HOLX  )

Health-Care Equipment

2,709%

Towers Watson

Human Resources

1,126%

EnergySolutions (NYSE: ES  )

Nuclear Waste Disposal

869%

IHS

Research and Consulting

808%

Kraft (NYSE: KFT  )

Food

582%

Iconix Brands

Apparel

484%

Ingersoll-Rand (NYSE: IR  )

Industrial Machinery

467%

Boston Scientific (NYSE: BSX  )

Health-Care Equipment

400%

Sources: Capital IQ, a division of Standard & Poor's, and author's calculations. Includes manufacturing, service, and retailing companies traded on major U.S. exchanges and valued at more than $300 million.

Of course, the Buffett Ratio isn't the be-all-end-all metric. Other characteristics, such as valuation, growth, managerial quality, and so forth, should be taken into account before making an investment. Moreover, the Buffett Ratio is deceptively optimistic for companies that rely on repeated investment in intangible assets.

But the metric is an excellent starting point for revealing otherwise hidden strong businesses, so let's dig a little further into these stocks.

What you need to know
Publishing giant John A. Wiley & Sons seems like an unusual name to top the list of companies with the best economics. The company's business involves the acquisition of significant intangible assets such as publishing rights, brands, and trade names, so I would consider this one to be a false positive.

Altria, the parent company of Phillip Morris USA, sells half of all cigarettes in this country. It's an addictive product marked by strong customer loyalty and pricing power.

Hologic makes imaging, diagnostic, and surgical devices for treating women. While the company is probably more profitable than traditional return on capital metrics indicate, its Buffett Ratio might be somewhat overstated because of the company's investment in research and development that's recorded on the balance sheet as intangibles.

Towers Watson is a human resources consulting company. It's a capital-light business based on pre-existing customer relationships.

EnergySolutions helps American and British governments and utilities clean up nuclear material. Although it has a few competitors such as Areva SA and CH2M Hill, this isn't exactly an industry that anyone can just enter. It should be cautioned, however, that the company is fairly highly leveraged and is liable to minority stakeholders and hedge funds, and there are also legal and regulatory risks.

IHS provides research and consulting for the oil and gas, manufacturing, security, and environmental industries. While some of its intangibles (like databases) may require reinvestment, there's a strong case to be made that this is a very profitable company.

Kraft makes a large number of major popular food brands that give it some scale and pricing power.

Iconix generates an enormous Buffett Ratio because its business-model is so capital-light. It owns -- but doesn't itself manufacture -- brands like Joe Boxer, London Fog, and Ocean Pacific.

Berkshire owns a small stake in Ingersoll-Rand, the Dublin-based company that makes a variety of heating, cooling, ventilation, security, and other machinery.

Like Berkshire holding Johnson & Johnson, Boston Scientific produces cardiac devices -- a high gross margin business given soaring U.S. health-care costs.

Of the companies listed above, Altria, EnergySolutions, Kraft, Iconix, Ingersoll-Rand, and perhaps IHS, Towers Watson, and Boston Scientific legitimately score highly on the basis of the Buffett Ratio.

I'll be keeping an eye on these and other stocks that I identify with excellent economics.

If you'd like to stay up to speed on the top commentary and analysis on these or any other stock you're interested in, click here to add it to your watchlist. You'll get free, personalized updates on companies you are interested in, as well as immediate access to a new special report, "6 Stocks to Watch From David and Tom Gardner." Simply click here to get started.

Ilan Moscovitz owns shares of Berkshire Hathaway. You can follow the Dada Portfolio on Twitter @TMFDada. Berkshire Hathaway and Johnson & Johnson are Motley Fool Inside Value choices. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Johnson & Johnson is a Motley Fool Income Investor choice. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Altria Group, Berkshire Hathaway, EnergySolutions, and Johnson & Johnson. Motley Fool Alpha LLC owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (30) | Recommend This Article (95)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 25, 2011, at 4:19 PM, Paulistano wrote:

    How can anyone have respect for someone who once said:"I'll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It's addictive. And there's a fantastic brand loyalty."

  • Report this Comment On March 25, 2011, at 4:43 PM, Boardman3 wrote:

    I have made money in stocks over the years and probably would have made more if I wasn't so puritanical. I do not buy stocks of companies involved in liquor, tobacco, or gambling.

  • Report this Comment On March 25, 2011, at 5:23 PM, MegaEurope wrote:

    The main thing this metric shows is that these companies have depreciated their tangible assets far below their real worth.

    Nothing wrong with that, but it's definitely not the best approach to stock selection. ROIC is a much more useful all-around metric.

  • Report this Comment On March 25, 2011, at 5:52 PM, tshk1221 wrote:

    Buffett created the ratio. The ratio mentioned here is not from a textbook. Based on his investment experience and deep thoughts over years and years, the ratio was created. We can create our helpful ratios, too. For example,

    Annual capital expenditure / annual earnings

    You can name it capital use ratio. The less it is, the more earnings a company can retain for dividends or other higher-yield investment in the form of acquisition of other businesses. Buffett chose the latter for BRK, which has been very fruitful to BRK owners.

    By the way, Buffett did like the tobacco business for its operating efficiency that requires very little capital reinvestment. The fact that Buffett does not invest in tobacco businesses anymore does not mean that he souldn't be given trust. In fact, he is worthy of absolute trust. If you don't trust a billionaire econo- philosopher / investor like Buffett, you can't be rich.

  • Report this Comment On March 25, 2011, at 5:55 PM, MegaEurope wrote:

    Did my comment post?

    The website seems to be going back to its bad habits of eating comments or not displaying them until the next post.

  • Report this Comment On March 25, 2011, at 8:08 PM, begavr wrote:

    I'm new to this, can someone tell me how to find or calculate unleveraged net tangible assets?

  • Report this Comment On March 25, 2011, at 8:19 PM, blackie45 wrote:

    I worked for Kraft foods for 10years at the time it was owned by altria.Altria split up the co. The only reason I still own Kraft is because of the dividend ,plus I recieved it basicly for nothing.

  • Report this Comment On March 25, 2011, at 9:02 PM, xetn wrote:

    Paulistano The tax on a pack of cigarettes is $1.01 per pack PLUS the state taxes.

    When I started smoking in the '40s (yeah, I'm an old fart that no longer smokes) a pack of cigarettes cost $.25. Just over $.01 each.

    Calculate the inflation rate since (say $.25 in 1950)is now costs $2.30. Source is the BLS' own inflation calculator http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=.25&year1=1...

  • Report this Comment On March 25, 2011, at 9:48 PM, midnightmoney wrote:

    Hi Ilan, thanks for the nice article. Could you comment on why Krakft scores such a gem on the buffett ratio but general mills doesn't appear? I'd be really interested to know.

  • Report this Comment On March 25, 2011, at 9:48 PM, midnightmoney wrote:

    Hi Ilan, thanks for the nice article. Could you comment on why Krakft scores such a gem on the buffett ratio but general mills doesn't appear? I'd be really interested to know.

  • Report this Comment On March 25, 2011, at 10:27 PM, stayabovewater wrote:

    I am watching and backing the (EMAN) stock could prove to be a gem. Also I have not given up on (SIRI) which has launched back seat TV and business solutions. I would not be confident with Leap Frog Stock since it depends on the desire of children to play with their products.

  • Report this Comment On March 26, 2011, at 12:33 PM, TMFDiogenes wrote:

    "Can someone tell me how to find or calculate unleveraged net tangible assets? "

    This isn't a terribly easy metric to calculate, but the way Matt and I interpreted Buffett, the ratio is:

    (Operating income * (1-effective tax rate)) / (Tangible book value+Total debt)

    Tangible book value = Total Equity - Goodwill - Other Intangibles

    Ilan

  • Report this Comment On March 26, 2011, at 12:46 PM, TMFDiogenes wrote:

    "Could you comment on why Krakft scores such a gem on the buffett ratio but general mills doesn't appear? I'd be really interested to know.

    Interesting question. General Mills scored 16% or so, which isn't terrible. The main difference is that it has more debt compared to it's tangible book value than Kraft does. It doesn't seem like their model/brands are much weaker, and General Mills has slightly better margins, so the disparity between the two companies probably isn't as cut-and-dry as the Buffett Ratio contrast would suggest.

    Ilan

  • Report this Comment On March 27, 2011, at 7:29 AM, wax wrote:

    Do you know how completely silly this sounds?

    Certainly I have a great deal of respect for Mr. Buffett and TMF, but perhaps Mr. Buffett has grown weary of thousands of websites using his thoughts and investing acumen to bring eyeballs to their sites.

    There was a time here in TMF land when staffers and contributors alike were able to present independent thoughts on investing that were intelligently and considerately discussed.

    Today, almost every TMF thought and article has something to do with something from Warren Buffett.

    How about let's forget Warren Buffett, let's stop using the S&P 500 as a measure against anything except the S&P 500, and let's get back to original thought and original content.

    Instead of focusing on this completely idiotic metric, perhaps you should focus on Buffett's thoughts.

    If you look around the room and can't spot the mark...your it; because that's what all of you are with this made up Buffett metric...marks.

    Have a clue guys!

    Wax

  • Report this Comment On March 27, 2011, at 12:48 PM, vaidybala wrote:

    Warren B likes stocks and owns that give dividends, but BRK does not. Is it not a conflict? You profess one thing and do the opposite.

  • Report this Comment On March 27, 2011, at 6:34 PM, TMFDiogenes wrote:

    "Warren B likes stocks and owns that give dividends, but BRK does not. Is it not a conflict? You profess one thing and do the opposite. "

    Great question. Tim Beyers and I have actually written about that issue:

    http://www.fool.com/investing/dividends-income/2010/05/28/th...

  • Report this Comment On March 27, 2011, at 6:44 PM, TMFDiogenes wrote:

    @Wax

    "Instead of focusing on this completely idiotic metric, perhaps you should focus on Buffett's thoughts."

    We write about his qualitative thoughts as well too. See the link in the previous comment, as well as Matt's article that I link to early in the piece for a few sources.

    "Perhaps Mr. Buffett has grown weary of thousands of websites using his thoughts and investing acumen..."

    Sometimes I wonder about that too, but nah, I think for the most part he loves the media attention. Otherwise he wouldn't give interviews, write lengthy letters to shareholders, or host massive shareholder meetings for hours every year. The prestige probably has an added benefit of helping him get more acquisition offers.

    I think if there's a new and useful lesson to be learned from reading Buffett, it's worth sharing.

    Ilan

  • Report this Comment On March 28, 2011, at 3:18 AM, AllanEdwards998 wrote:

    "Can someone tell me how to find or calculate unleveraged net tangible assets? "

    This isn't a terribly easy metric to calculate, but the way Matt and I interpreted Buffett, the ratio is:

    (Operating income * (1-effective tax rate)) / (Tangible book value+Total debt)

    Tangible book value = Total Equity - Goodwill - Other Intangibles

    Ilan

    ___________________________

    Impressive ratio. I had no idea what Buffett was talking about when he said unleveraged capital but your ratio looks correct after seeing it.

    I just wonder why anyone would care about unleveraged capital. It seems like it would only be a useful measurement if the business itself had no leverage and then you could calculate the business by using ROE. Or return on tangible equity.

    I think Buffett's theory doesn't really work for actual investments. Since shareholders don't own debt and interest payments. So the formula is pretty useless for calculating the value of a stock.

    But I am guessing its good if your considering buying a whole business, since you can buy-out the debt

  • Report this Comment On March 28, 2011, at 3:37 AM, AllanEdwards998 wrote:

    After more thought I don't think your formula is correct. Buffett says earnings on unleveraged net tangible assets but your ratio shows unleveraged earnings on total capital and not net tangible assets.

    Therefore the formula must be

    Operating earnings * (1-Tax Rate)

    ____________________________

    Net Tangible Assets

    So the ratio would be used if your going to buyout another company.

    The way you did it is less intuitive since if someone bought a business and bought out all the debt equity would remain the same.

    So with my ratio the numbers remains the same but under yours if you buy the company and buyout the debt the number substnatially changes.

    contact me at allanedwards100@hotmail.com for further explanation

    thanks for the quote though. I love Buffett quotes.

  • Report this Comment On March 28, 2011, at 9:51 AM, barrycahn wrote:

    Confirming that we're on the right track, two of the 10 companies listed -- Kraft and Ingersoll-Rand -- are already Berkshire holdings.

    Doesn't this make it seem like the author wants us to believe that the other 8 are "not yet" owned by Berkshire? From my point of view, the title of the article should be The Top 10 Buffett-TYPE Stocks.

  • Report this Comment On March 28, 2011, at 11:23 AM, mtf00l wrote:

    Only Buffet and maybe Munger know what method Buffet uses to pick stocks and businesses....

  • Report this Comment On March 28, 2011, at 6:34 PM, TMFDiogenes wrote:

    I still think we got the denominator right -- the phrase Buffett uses is "unleveraged net tangible assets", so it makes sense to add total debt back to net tangible assets. If we didn't add it back, it would just be net tangible assets.

  • Report this Comment On March 28, 2011, at 6:36 PM, TMFDiogenes wrote:

    One thing I like about it is that it provides a different picture than roe. Roe can provide an advantage to companies that use lots of debt. In part, it measures the efficiency of their capital structure, in addition to the economics of the business. By stripping away that factor, the Buffett Ratio may give a clearer picture of the economics of a business. That's one way of thinking about it.

  • Report this Comment On March 28, 2011, at 6:41 PM, TMFDiogenes wrote:

    "Confirming that we're on the right track, two of the 10 companies listed -- Kraft and Ingersoll-Rand -- are already Berkshire holdings.

    Doesn't this make it seem like the author wants us to believe that the other 8 are "not yet" owned by Berkshire? From my point of view, the title of the article should be The Top 10 Buffett-TYPE Stocks."

    The other 8 aren't owned by Buffett. If you read to the end, I give the analysis that I think the Buffett Ratio yields for the other 8.

  • Report this Comment On March 29, 2011, at 8:10 PM, AllanEdwards998 wrote:

    "I still think we got the denominator right -- the phrase Buffett uses is "unleveraged net tangible assets", so it makes sense to add total debt back to net tangible assets. If we didn't add it back, it would just be net tangible assets."

    Yes but if all the debt was bought out IE your doing (Op earnings - 1- tax rate) / Net tangible assets.

    Then your already doing earnings to unleveraged net tangible assets.

    Buffett would have said earnings to total capital if you were correct.

    I am 100% sure I am right that buffett was using (Operating Earnings *(1-TR) / Net Tangible Assets

    Either way good article.

  • Report this Comment On March 30, 2011, at 2:14 AM, louchios50 wrote:

    5-10 yr good graph, fundamentals , mngmt. I'll buy the dips and ride out anything.

  • Report this Comment On April 01, 2011, at 11:54 AM, mlivatino wrote:

    I'm sorry to see so many comments that have nothing to do with investing and everything to do with genuflections of the ego to its own self, or what might be called goodness-on-display. I suggest to those folks who have no respect for Warren Buffett because he invests in Altria that, like him, they donate nearly all of their wealth upon death to charity. He does more good in this world than all these people put together and millions more like them with their goodness-on-display.

  • Report this Comment On April 03, 2011, at 2:08 PM, RedDogue wrote:

    At the risk of being showing my lack of skill (stupidity), I have to say I don't compute this stuff myself. I compare the experts results in spreadsheets. I don't trust myself. Does anyone know how much Buffett makes in Dividends? I only saw one maybe 2 people comment about that. Does 1.7Bil - 2 Bil annually sound about right? I am not sure I had all his stocks correctly; but I came up with a phenonmenal figure like 1,650,000,000 in annual stock dividends. No wonder he is a billionaire. I dropped BRKB, since there were no dividends and the price is based on those stocks going up, I don't see me getting rich on that. What am I missing about his stock fund?

  • Report this Comment On April 05, 2011, at 8:34 PM, 5QwCp7yB8 wrote:

    @wax,

    Yeah, thanks Wax, for the S&P500 mention.

    Has anyone else noticed how the Fool, this "oasis of integrity", measures all of their stock-picking services against the S&P? Services that offer a couple picks a month of small unknown undervalued under-followed companies or trade derivatives, foreign stocks, etc. Against the most well known, well-followed, well capitalized stocks. (Average mkt cap approaching $50 Billion - let's find a ten bagger there.) Oh yeah, in an unmanaged, constantly re-weighted fully-invested index WEIGHTED BY MARKET CAP. Any publicly regulated investment fund would be sanctioned at the least.

  • Report this Comment On July 19, 2011, at 4:41 PM, azaw wrote:

    Since I'm just a novice, could someone post an example using the Buffett Ratio and indicate where on the financial information (balance sheet? cash flow? and what line?) for the company the figures are derived? Or is there a MF investment for newbies lesson that covers this in detail? Thx.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1464900, ~/Articles/ArticleHandler.aspx, 11/25/2014 8:41:21 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement